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While a broad market approach is a popular investment style for many, some like to take a more concentrated look at large cap stocks. One way of narrowing down the field is by looking at earnings quality.

This technique looks to use publically available financial reports to hone in on aggressive accounting practices. These bookkeeping tricks can often be an attempt by management to cover up weakness and thus are issues that investors want to know about before getting into a stock (read 3 Multi-Asset ETFs for Juicy Yields and Stability).

Generally speaking, finding these issues is known as ‘forensic accounting’ which is a process that looks to find a number of ‘red flags’ which can signal weak earnings quality, and possibly future troubles for a stock. These include, among others, the following issues: fictitious revenue, inventory problems, ratio adjustments, accelerated revenue recognition, and unsustainable margin expansion.

By identifying these issues, investors can avoid these weak earnings companies and instead zero in on those who have high quality balance sheets and other financial statements. While this somewhat time consuming process can be done on a stock-by-stock basis, it is now available in ETF form as well.

This is thanks to a new product from Exchange Traded Concepts, the Forensic Accounting ETF (FLAG - ETF report). The ETF looks to track the Del Vecchio Earnings Quality Index, charging investors 85 basis points a year in fees for this low earnings quality avoiding exposure (see Can You Beat These High Dividend ETFs?).

FLAG in Focus

The underlying index looks to take all 500 stocks in the S&P 500 and grade them on a traditional A-F scale on a monthly basis for their earnings quality. Firms that are rated ‘A’ make up 40% of the index, while those graded ‘B’ ‘C’ or ‘D’ make up the remaining 60% of the fund (with each grade taking up 20% each).

Stocks that receive a grade of ‘F’ are not included in the fund, leaving a portfolio of about 400 stocks. It should also be noted that within each letter grade, stocks are equally weighted, giving the portfolio a tilt towards the top grade level which are the stocks that have the best earnings quality.

For the purposes of the index, this earnings quality is defined as the degree of sustainable earnings as reported by a company. Some of the key areas that are analyzed with the proprietary methodology include looking at gross profit for reserve concerns, COGS for inventory issues, and revenues for aggressive recognition procedures.

Can It Succeed?

The fund is based on the work of John Del Vecchio who has made a name for himself in the forensic accounting-based investment world. He is already the co-manager of the short-only fund (HDGE - ETF report) which looks to bet against firms that have low earnings quality (see The Truth about Low Volume ETFs).

This ETF is only of the only short focused products on the market and costs a pretty penny at 3.3% in net expenses a year. Still, the ETF has close to $200 million in AUM so investors have clearly embraced the strategy for their portfolios.

Now that the ability to look at earnings quality is available in a long-only product, we could see a similar level of interest for FLAG despite its relatively high—when compared with products like (SPY - ETF report) or (VOO - ETF report)—expense ratio of 85 basis points a year.

This will be especially true if FLAG can provide investors with a solid level of outperformance, and if the tilt away from low earnings quality firms can reduce volatility and improve risk-adjusted returns for investors (see 4 Best New ETFs of 2012).

If this is the case, Del Vecchio could have another winner on his hands with the forensic accounting-focused ETF, giving more credence and publicity to the investing style for all stripes of investors.  

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